Much hay is being made this week regarding the April Consumer Confidence number, which compared to the monthly change in the S&P 500 index showed the widest-gulf on record since 1978, when the University of Michigan survey began. The explanation offered in the financial press is that this supports the “dislocation” theory of the stock market and the economy.[1] What has not been widely reported is the second part of that survey that covers Consumer Expectations, which have remained relatively strong and stable. Important to note is how this led the 2009 recovery.
We are monitoring the job market very closely to see whether consumer expectations are able to play out as the economy reopens.
The recent Memorial Day holiday weekend offers a very telling sign that consumers are responding favorably to the economy re-opening. Based on the significant and widespread jump in retail activity compared to the beginning of the month, we find some measure of optimism is warranted.
https://fingfx.thomsonreuters.com/gfx/editorcharts/xegpbymlzvq/eikon.png
And in the meantime, the path of the virus continues to head in the right direction with daily cases continuing to decline in the U.S., even with a number of areas of the country several weeks into their re-opening.
Fixed Income Review
For the last few years we have seen an uptick in headlines around debt-laden companies and municipalities. These concerns have once again come to the forefront during this crisis as future cash flows are more uncertain. Over the last two months the amount of debt classified in the U.S. as distressed has surged 161% and in April alone, corporate borrowers defaulted on $35.7 billion of bonds and loans, the fifth largest monthly volume increase on record according to J.P. Morgan.
Historically, the investment grade corporate sector has experienced a 3.6% default rate.[2] COVID-19 has super-charged and exposed many problems that pre-dated the pandemic. Many of these weaker firms facing challenges have struggled for years, and the recent economic turmoil has accelerated the reality of what was likely to play out over time, and compressed that into just a few months. In general, these companies are in challenged sectors, have weak balance sheets, questionable business models and / or poor management.
These at-risk companies are generally focused in a few sectors with approximately 33% of the defaults in consumer discretionary (majority coming from retail); followed by energy at 21%. Defaults include J. Crew, Neiman Marcus, J.C. Penny and the recent filing by Hertz.
Take Hertz as one example: A company that was poorly managed with high CEO turnover, four in just a few years. The company took on huge amounts of debt to finance its acquisition of Dollar Thrifty, and mismanaged its fleet (i.e., it emphasized sedans, only to have consumers demand SUVs, and then faced weak used car values when disposing of such inventory).
In the case of the Energy sector, most of the at-risk companies have been smaller players in the exploration and production space that had very weak balance sheets, and were structured for oil production at much higher prices.
So we find ourselves in a situation where, with the support of the Fed, market liquidity has started to improve the overall health of the market, while at the same time we have seen an uptick in challenged businesses.
The $3.9 trillion dollar municipal bond market remains a highly-rated market. Although defaults are headline-grabbing like Puerto Rico or Detroit, they are extremely rare. Investment grade municipals have defaulted at a rate of 0.28% since 1986.2 The areas most prone to default include specific project-financed bonds, and bonds focused around hospitals and healthcare. Data compiled by the Pew Charitable Trusts shows the vast number of states entered this crisis much stronger relative to 2007 (prior to the Global Financial Crisis) based on Rainy Day Fund levels, and they are now being supported by additional Fed assistance. This support has led to a strong rally in municipal bonds from the lows, even allowing for some of the more challenged credits to gain access to the market.
[1]https://www.wsj.com/articles/the-stock-market-and-consumer-sentiment-are-telling-different-stories-11590571805?mod=searchresults&page=1&pos=4
2 Source: S&P. For municipal defaults, S&P’s study period was Jan. 1, 1986, to Jan. 1, 2019. For corporate defaults, S&P’s study period was Jan. 1, 1981 to Jan. 1, 2019. The calculation represents a 15 year cumulative default rate.
3 Pew Charitable Trusts https://www.pewtrusts.org/en/research-and-analysis/articles/2018/08/29/states-make-more-progress-rebuilding-rainy-day-funds
